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Monday, February 8, 2010

The Eurozne: Deja Vu Argentina 2001 & Other Thoughts

The sovereign debt problems in the Eurozone periphery and the implications of this development for the future of the currency union attracted a lot of attention over the weekend. Here is the New York Times on the problems facing Greece and the Eurozone more generally. Carmen Reinhart, meanwhile, tells us that Greece has been in a state of default about 50% of the time since the 1830s (Why then, was it ever allowed to join the Eurozone?). More importantly, she indicates that if some of the Eurozone's periphery goes under then the problems in Eastern Europe become more severe. Here is CNN quipping that Europe's PIGS (i.e. Portugal, Italy, Greece, and Spain) don't fly. Here is Paul Krugman lamenting the monetary stratightjacket that is the Euro. Finally, here is Simon Johnson pulling a Roubini by forecasting these problems, if not addressed, risk causing another global depression. After reading all these pieces, here are some thoughts:

(1) I couldn't help but think of Argentina's crisis in 2001-2002. It too had a sovereign debt problem, an overvalued real exchange rate, and was effectively part of a currency union that did not meet the optimal currency area criteria. It too tried to cut wages and prices but found the deflationary price too high. Ultimately Argentina defaulted and broke the peso-dollar link, even though the currency board linking the two currencies was almost a decade old and considered an important institution. It seems possible some of the PIGS could go the way of Argentina.

(2) On the other hand, Tyler Cowen reminds us that there would be a great cost for Greece's banking system if the nation chose to leave the Eurozone. Barry Eichengreen lists other costly barriers any Euro nation would face in such a move. Maybe this is why the intrade.com contract on any country leaving the Eurozone in 2010 is hovering around 15% (down from a high of 40% in late 2008). Still, Argentina faced similar costs and it abandoned the dollar peg. Never say never.

(3) This New York Times article makes the case the ECB president, Jean-Claude Trichet, has more power because of this crisis. Since there is no EU Treasury to help Greece, the only institution capable of bailing out the PIGS is the ECB. According to the NYT, this makes Trichet the de facto president of Eurozone. Given all the animosity the Federal Reserve has generated for itself in the financial crisis from the new public awareness of its power, I wonder if something similar could happen to the ECB if it chooses to use its power for the PIGS. The U.S. public has always had some aversion to centralized monetary power (e.g. Andrew Jackson's Second Bank War, the hatred of Paul Volker in the early 1980s). Europe may be more open to such uses of monetary power given their longer history with central banking.

(4) Ultimately, this crisis speaks to the importance of a monetary union meeting the optimal currency area to be viable. I have made this point before, but will leave it with Paul Krugman to make the case here:

Spain is an object lesson in the problems of having monetary union without fiscal and labor market integration. First, there was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.

If Spain had its own currency, this would be a good time to devalue; but it doesn’t.On the other hand, if Spain were like Florida, its problems wouldn’t be as severe. The budget deficit wouldn’t be as large, because social insurance payments would be coming from Brussels, just as Social Security and Medicare come from Washington. And there would be a safety valve for unemployment, as many workers would migrate to regions with better prospects. (Wages wouldn’t have gone up as much in the first place, because of in-migration)... what’s happening to Spain reflects the inherent problems with the euro, which now more than ever looks like a monetary union too far.

1 comment:

In and of itself a Greek bankruptcy or bond default should -in theory- not affect the Euro as such very much, Greece being maybe 3% of the total. However, just as a Californian bankruptcy would reflect badly on the "state of the Union" as a whole so would the default of on EU country, coupled with the rising interest rates and thus further destabilisation of the remaining over-leveraged member states, make investors wonder when sovereign default across the board is likely. Thus they wouldn't commit themseves to bonds of longer maturity and that's the beginning of the end.